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The Economics of the National Security Buildup

November 8, 2002
Council on Foreign Relations

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[Note: A transcript of this meeting is unavailable. The discussion is summarized below.]

ROUNDTABLE FINDINGS REPORT

Presider and Project Director: Ann R. Markusen

The first of three speakers discussed the size of the military budget, the economic impact of increased military spending, and the effect upon the private sector of a national security buildup. The second speaker addressed the oversight of government spending, and in particular, problematic aspects of defense spending. The third speaker then explained how the defense industry is changing, and how the Department of Homeland Security will be a powerful vehicle driving that change.

Size of the military budget

The military budget is difficult to calculate as it is a moving target, yet it is currently about $300 billion, which is 3% of GDP. The projected budget for 2003 is $384 billion, or 3.8% of GDP. Therefore, the spending increase from 2002 to 2003 is .8% GDP. This figure, however, does not incorporate the cost of a war in Iraq.

Though the cost of a war in Iraq is uncertain, it would likely involve a one-time expenditure of .3-.5% of GDP, and an additional .3-1.0% of GDP in the case of an occupation afterwards. To give the participants a sense of the size of this spending increase, the speaker remarked that the cost of making social security solvent would be about .72% of GDP. The increase in military spending, therefore, involves a 40-50% greater outlay than does guaranteeing social security.

Economic impact of the military budget

The impact on the economy of a military buildup, the speaker continued, will be a rising deficit, leading to a decrease in GDP of 1-1.5%. To put such a drop in GDP into perspective, the speaker explained that U.S. support for the Kyoto accord on climate change would lower GDP by about 1% after 10 years. President Bush has said that such a reduction is unacceptable. We can assume, therefore, that he would consider the economic effect of this military buildup unacceptable if the purpose were to alleviate climate change.

Effect upon the private sector of a military buildup

Finally, the private sector pays a price for military buildup as homeland security is increased in places such as airports and large buildings. The Congressional budget office estimated that the cost of homeland security would be equivalent to the reduction in productivity growth of about .1% per year. Carried out ten years, this slower growth leads to a reduction in GDP of 1% by 2012, and a reduction of 1.5% by 2017.

In short, the price of a military buildup is significant when compared with that of other policies, such as the Kyoto agreement and social security, which have raised a great deal of concern due to their cost.

The oversight of defense spending

The second speaker focused her comments on the difficulties of monitoring government defense spending. The federal government is the largest consumer of goods and services in the world, and the defense budget makes up two-thirds of federal procurement spending. Yet free market forces often cannot regulate the price of products purchased by the government. The federal government frequently is the only consumer of weapons systems, and these systems are made by very few companies. Thus, the prices of such goods are determined by the parties involved in the transaction, and not by the market.

Throughout the 1980s, Congress instituted a number of procurement reforms, including standards for defense contracts, rules for accounting practices, and requirements for cost and pricing data. The Pentagon’s Inspector General reported that these reforms resulted in dramatic increases in competitive procurement and savings in the 1980s. In the 1990s, however, the defense industry mounted an offensive against the overbearing system. This effort was a hallmark of then Vice-President Gore’s “reinventing government” initiative, and was given the media-friendly moniker of “defense acquisition reform.” The legislative provisions created concepts such as: “competitive one-bid contracting,” “commercial items that are only bought by the government,” information about cost and pricing that “need not be current, accurate or complete,” and “indefinite delivery, indefinite quantity contracts.”

The results of procurement standard shifts, however, are not encouraging:

• In May 2001, the Department of Defense audited 145 sole-source and competitive one-bid contracts. The auditors exposed overpricing in more than one-third of the contracts, and in the vast majority of the remaining cases, they were unable to determine whether or not there was overpricing due to inadequate data.

• In 2002, the Associated Press performed a computer analysis of all Pentagon procurement, and found that in half of all transactions, goods and services were bought without any competition. In other words, $123 billion of the $230 billion worth of goods and services bought were attained without any bids, or with methods that bypass competition.

• Commercial item procurement, too, has become permissive and troubled. Goods such as military cargo planes are considered commercial, yet cost and pricing data for items defined “commercial” are not available to the government. In 2000, the General Accounting office reported that the prices of 3,000 spare parts, purchased through this commercial price system, had increased by ten times or more in one year.

• Credit cards for micro-purchases (under $2500) were introduced as part of the acquisition reform, yet have been abused. Meant to speed up purchasing time by removing normal internal accounting controls for inexpensive purchases, the cards have been found to buy personal items such as breast enlargements and lap dances.

• Secretary Rumsfeld recently waived most cost and testing oversight of the $8 billion ballistic missile defense program by allowing the use of an agreement called “other transactions” rather than normal contracting rules. His intention was to encourage new, smaller, innovative companies to bid on ballistic missile defense contracts. However, the two transaction agreements that have been signed to date are with Boeing and Lockheed Martin. Hardly newcomers to defense contracting, they will not need to provide cost and price data, and can even be exempt from government audits.

With defense spending set to increase sharply due to new homeland security measures and a likely war with Iraq, acquisition reform of the last decade has put the government in a dangerously vulnerable position. It is not only possible for contractors to get away with overcharging the government, it is very likely. The procurement system has sacrificed openness, fairness, economy, and accountability for the sake of efficiency and ease of contracting. We now have a pseudo-efficiency that has resulted in greater costs.

The future of the defense industry

The third speaker then addressed the ways in which the defense industry is changing.

• One of biggest changes in the post-9/11 environment, he explained, is that the industry has gone from being “in the doghouse” to being one of the darlings of Wall Street. The poor performance of NASDAQ led to the reallocation of funds within market as people recognized that defense budgets were going to increase. $6 billion was raised by companies that specialize in such things as homeland security and biometrics. Many governmental information technology companies also benefited as they went public. Thus, a sector that two to three years had little access to capital, found itself flooded with capital from Wall Street.

• In the coming months, new demand in areas such as homeland security will offer defense companies greater opportunity. The greatest challenge for the new Department of Homeland Security will be to develop information-technology architecture. Defense and non-defense companies will compete for the business of this department, which has a $36-37 billion budget.

• Changes since 9/11 have strengthened the emphasis on transformation; the FY04 defense budget will be very revealing. The army in particular will see many of its programs cancelled as the office of the secretary of defense transfers money to programs it believes are transformational in nature. This transfer will have industrial impact.

• The Department of Defense is trying to change its relations with the industry by broadening the number of contractors it uses in order to shorten development time and ready products for the market more quickly. The speaker, however, expressed skepticism that such a shift would be successful.

• Unlike defense spending of the 1950s, which was an engine of technology development for products like jet engines, missiles, and large scale computers, the current spending increase of 3% of GDP will not cause much technology spin. In fact, the speaker felt, many defense companies would pull money out of the commercial sector, particularly information technologies.

• Finally, the speaker remarked that trans-Atlantic defense cooperation has evaporated. France and UK are increasing their budgets a bit, but Germany and northern European countries’ budgets are decreasing. U.S. companies are focused on U.S. markets, and even European companies are trying to access markets in the United States instead of those at home.

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